Emerging Markets – Time to Buy?

Volatility and currency risks are omnipresent but a good strategy can increase returns in such an environment.

Introduction

Only positive news comes from the US economy, from housing growth to the Federal Reserve Chairwoman Janet Yellen signaling a rate hike. All this news is pushing the S&P 500 towards reaching new highs. Yet a stronger dollar in the longer term will mean cheaper imports and more expensive exports. This perspective inevitably leads toward contemplating investing into emerging markets as they are currently shunned by the investment community due to their relative underperformance and slump in commodity prices. But, going by the maxim that the best returns are made by going where no one wants to go, this article is going to provide analysis on emerging market opportunities.

Current Situation in Emerging Markets

According to Bloomberg, global investors pulled $735 billion out of emerging markets with China accounting for 90% of it. This resulted in a sharp decline in the iShares MSCI Emerging Markets ETF that tracks the MSCI emerging markets index which fell by almost 20% in the last 12 months, but was also down 31% in January.

The MSCI emerging markets ETF consist of 23 countries representing 10% of global market capitalization with the greatest weights attributed to China (23.89%), South Korea (15.29%), Taiwan (12.18%), India (8.1%), Brazil (6.58%) and Russia (3.75%). The PE ratio of the iShares MSCI Emerging Markets ETF is 11.44, the price to book value is 1.4 and the current distribution yield is 3.17%. Emerging markets have a PE ratio that is only 47% of the S&P 500 PE ratio, the price to book ratio is only 49% and dividend yield is 1.5 times higher than the S&P 500. As 23% of the S&P 500 revenues are generated in emerging markets, it seems logical to buy exposure to emerging markets directly at a much lower valuation.

This cheapness and decline in emerging markets was mostly caused by weaker currencies in relation to the dollar, less available capital due to the discontinuation of the US quantitative easing and low commodity prices. With low commodity prices, countries that are rich with natural resources like Brazil or Russia find it difficult be liquid which further ignites a spiral of downgrades and capital outflows.

Risks Related to Emerging Markets

The situation is bad; can it get worse?

The answer is simple: yes. Further increases in US interest rates will create a stronger dollar with higher yields and more money could be pulled out of emerging markets. A stronger dollar lowers global commodity prices and emerging countries have less liquidity on which to count on, especially as many have bigger parts of their debt in foreign currencies.

Weak commodity markets also push down capital inflows and further destabilize emerging economies. It is impossible to exactly catch the bottom or to know if the current pull back is just a temporary one or the start of a long term trend, so the best way to approach emerging markets is to weight one’s exposure to them. There are several reasons why emerging markets portfolio exposure should be beneficial.

Reasons to be Exposed to Emerging Markets

The January 2016 International Monetary Fund outlook forecasts global GDP growth at 3.4% for 2016 where developed economies are expected to grow at 2.1%, while emerging markets are expected to grow at 4.3% despite the above mentioned difficulties. Asia is expected to be the leader in growth with 6.3%, while Latin America and Russia are expected to contract in 2016 and rebound only in 2017. South America and Russia drag emerging markets down, but from an investing perspective the best time to invest is when times are difficult.

The already mentioned lower valuations should provide excellent diversification to your portfolio, albeit a volatile one. Also, any weakness in the US and the dollar would quickly reignite interest for emerging markets and make those interest rates more attractive, thus pushing emerging currencies higher.

The US interest rate of 0.5% seems really low when compared to emerging markets, therefore exposure to other countries should provide good long term diversification. The volatility of emerging markets is bad when they fall, but could be an extraordinary tailwind if they rebound.

Any pickup in emerging markets economies, or a more positive outlook, could quickly reverse the current trend and push the emerging markets index towards the highs seen in 2007 and 2011, or even higher. It is difficult to expect returns in excess of 50% from the S&P 500, while it is a possibility with emerging markets, but larger losses are also possible.

Conclusion

Investors do not like emerging markets at the moment, so if you have the guts to buy something others dislike and fight the trend, you might be rewarded with extraordinary returns or extraordinary losses. Fortunately, markets do not just obey investors’ sentiment, but also have fundamentals and fundamentals are on the emerging markets side.

As there is a possibility of further declines for emerging markets, a good strategy is to have a proportional weighted exposure to them. By always keeping the same percentage of your portfolio in emerging markets, you get the nice dividend yield, trim your position when markets go up and buy more when markets are cheaper. ETFs give the best opportunities to follow such a strategy.